My Bias on High-Risk Mortgage Loans

So if you want to say that Fannie and Freddie need major reforms because they took on an unacceptably high level of risk, particularly for taxpayer backed entities, welcome to the club. I don't think there's anyone who will disagree with you, certainly not anyone I've met who's studied the data even a little bit. On the other hand, if you want to argue that Pinto's "high risk" loan categories (which you are apparently agreeing are comparable to prime conforming loans) are equivalent to PLS subprime, or even PLS generally, you are completely ignoring all the data.

In fact, I probably would not go with Ed Pinto's definition of high-risk loans. That is because of my bias, based on the pricing models that I helped develop. My bias is to treat the propensity for default as a function of borrower's equity. I put a lot less weight on factors related to credit history, income, and so forth. Yes, those factors matter at the margin, but you could never convince me to price a loan with a 95 percent loan-to-value ratio as less risky than an owner-occupied purchase loan with an 80 percent loan-to-value ratio, no matter how great the credit score you had on the 95 % LTV loan.

Let me explain here my bias against cash-out refinances. When somebody purchases a home, they have an incentive to negotiate the lowest price that they can get for a home. Therefore, when the appraisal comes in at the sales price, I do not worry about the appraiser's judgment. Even if the appraiser did nothing to justify the price, the buyer is presumably not an idiot who would pay a big premium over market. But when it's a cash-out refi, then I am totally relying on the appraiser's judgment. And I know that the mortgage broker is going to "shop the appraiser" until he gets the "right" number. So I do not trust the appraisal, and therefore I cannot trust the loan-to-value ratio.

A cash-out refi is really a consumer loan, which may or may not have collateral behind it. I do not know how to price consumer loans. I claim to be able to price mortgage loans.

My other bias is against mortgage loans for investment properties. The problem there is you have the "ruthless defaulter." Somebody whose house declines in value to a point below the outstanding loan balance will often continue to make payments, because they live there. But if you invest in a house and its value falls below the outstanding loan balance, you turn in the keys to the lender.

My idea of a safe loan is a loan-to-value ratio of 80 percent or less that is not a cash-out refi or an investor loan. Give me those characteristics and I am not going to worry about the credit score and the loan documentation. The NINJA loan, where the income, job, and assets of the borrower are not verified, would make me a bit nervous, but the 20 percent or more in equity would probably overcome that. As long as house prices do not fall by more than 20 percent, I don't expect to lose money on that loan.

On the other hand, if you offer me a loan with a loan-to-value ratio over 90 percent, or a cash-out refi, or an investor loan, I have to price that loan as very risky. All it takes is a slight decline in house prices to make that a bad loan. Any of those types of loans is a risky loan, the way I look at it. (Well, an investor loan with a 50 percent LTV is probably ok).

In that sense, I think all the talk about "sub-prime" is to me a big head fake. When I think of the growth of high-risk loans in the decade leading up to the crash, I think of investor loans (which more than tripled as a percentage of total mortgage loans, according to the work of Avery and others), cash-out refis, and high-LTV loans.

In my opinion, the industry became way too obsessed with FICO scores. I was a big fan of credit scoring, but mostly because for low-risk loans I wanted to bypass the human underwriters, who I suspected added little value.

I will bet that low-risk loans, by my definition, had a default rate of much less than 5 percent, even if they were originated in 2006 or 2007. I may be overly optimistic about that, but I would like to see the numbers. My sense is there were not all that many loans done at that time that met my criteria for low risk.

Think of a Venn Diagram. Circle A includes loans that are high-risk by my definition. Circle B includes loans that are risky by other criteria, such as pay-option ARMs NINJA loans, or loans to subprime borrowers. My guess is that there was huge overlap between circle A and circle B. However, if you gave me a choice, I would prefer a portfolio of loans outside of circle A, even if they include some loans in circle B. I think that most other people, when they talk about risky mortgage loans, make it sound as if they would be fine with loans outside of circle B, even if they were in circle A. I think that's wrong. But you have to slice and dice the data more carefully than I have seen in order to know for certain.

Comments and Sharing

Dr. Kling, I have to confess, at this point I don't think I understand your critique. Are you simply saying that LTV>90 loans are riskier than LTV

But these are all independent points from (and actually consistent with) my critique of Wallison/Pinto. Saying a loan is riskIER is different than saying it is "high risk"/subprime-equivalent, which is the central assumption of the Pinto research under dispute. However you look at the data, it's clear that GSE loans, including those loans that fall into the disputed "Pinto high risk" categories, are dramatically less risky than PLS or subprime.

To put it another way, you may think that anyone driving over 35mph on a freeway is a "risky driver", but you would have to acknowledge that there is a significant difference between someone driving 50mph and 100mph. To simply call these all "high risk drivers" as if they were a homogeneous set of risks is flawed.

Dr. Kling, I have to confess, at this point I don't think I understand your critique. Are you simply saying that LTV>90 loans are riskier than LTV80 loans? Then yes, I agree with you (as do the regulators, which is why Fannie/Freddie had to hold more capital against those loans). Are you saying that all loans above a certain threshold are too risky for your personal preference? Fine.

But these are all independent points from (and actually consistent with) my critique of Wallison/Pinto. Saying a loan is riskIER is different than saying it is "high risk"/subprime-equivalent, which is the central assumption of the Pinto research under dispute. However you look at the data, it's clear that GSE loans, including those loans that fall into the disputed "Pinto high risk" categories, are dramatically less risky than PLS or subprime.

To put it another way, you may think that anyone driving over 35mph on a freeway is a "risky driver", but you would have to acknowledge that there is a significant difference between someone driving 50mph and 100mph. To simply call these all "high risk drivers" as if they were a homogeneous set of risks is flawed.

I remain confused by the apparent claim that Fannie and Freddie had little to do with PLS loans. The GSEs accumulated a large portfolio of PLS loans. Loan originators knew that they could sell their loans to the GSEs after securitization, and as long as the GSEs were a buyer of last resort (and determined to maintain market share), I don't see how you can say that it had so little to do with them.

Surely fewer subprime loans would have been originated outside the GSEs if it weren't known that the GSEs would buy them in securitized form or not.

"They did not purchase nontraditional mortgages in any quantity until the U.S. homeownership rate had already peaked in 2005. The bulk of risky mortgages the GSEs did acquire or guarantee after 2005 were not “subprime,” but largely “Alt-A” mortgages that were made to borrowers with “prime” credit scores and relatively sizeable equity contributions.The magnitude of GSE credit losses is mostly attributable to a combination of acquisition of Alt-A and other 'prime-like' mortgages and making the purchases at the height of the housing bubble."

As a loan processor, I don't understand your claims about cash-out refinances. I agree with your assessment of lower LTVs, but don't understand your repeated gripes with cash-out refis. They require a max LTV of 80% for goodness sake! Our business doesn't operate as a mortgage broker, but we used to until recently. Are you familiar with the reforms made to HVCC? Brokers cannot, I repeat brokers cannot, "shop the appraiser." That used to be true at one point, but brokers now have to order appraisals through appraisal management companies. And my experience with many refinances, including cash-out refinances, is that lenders won't hesitate to outright reject appraisals, even conservative ones, if there aren't similar enough comparable properties. And appraisers tend to be more cautious given the risk of being blacklisted by lenders or losing their licenses. Another important thing to remember is that cash-outs provide an important avenue for borrowers with second mortgages. Many individuals who take out cash-out refis do so to pay off a first and second mortgage in exchange for lower payments, which would likely reduce default risk.

Would 20% down payments be largely superfluous in recourse states? A naive observer like me would expect that to have ''skin in the game'' you need either a stake (20% down), or the threat of recourse to discipline home-buyers, but not both.

My bias is to treat the propensity for default as a function of borrower's equity. I put a lot less weight on factors related to credit history, income, and so forth.

That makes a lot of sense. "Credit history, income, and so forth" changes on a dime: a layoff, bad business decision, triplets attending Stanford, medical catastrophe. While you can't account for that, you can count on a person with unchanged personal circumstances staying in their home if he has equity, and likely leaving it if sufficiently under-water (i.e., sufficient to make it worth the hassle of moving, taking a credit hit).

This is really the wrong way to think about risk. Loans have to be paid for and only income can insure there are sufficient funds to do so. Income is what determines and limits prices to affordability. Cash flow is king. Appraisals are better than nothing but if lenders are willing to lend $1M on $500K properties (properties that buyers only have the income to afford), properties will appraise at $1M. If next year lenders are willing to lend $2M, prices and appraisals will rise to $2M. If they decide they will no longer lend more, prices will no longer rise and payments will have to be paid out of income since there will be no more capital gains. At this point the house of cards collapses because there was only ever enough income to support $500k, except with the dislocation and unemployment there is no longer even enough income to support that.

It is the lenders responsibility to say no to those who cannot afford to buy. They do no favors to anyone saying yes. Where was the 50% increase in incomes to pay for these? Were they expecting that to happen next year? Then they should have to wait for that to materialize before buying. Forging asset prices is easy, but forging income is quite difficult unless no one bothers to check.

A lower LTV is safer, but only relatively. Once escalation is underway and prices are rising 20% per year, even 80% becomes highly risky since they can double their money annually. While 80% can slow the initial rise, once broached, it would create an even larger boom and crash due to massive momentum.

Okay, but being able to come up with a 20% downpayment shows something solid about the borrowers. Much of the other data about borrowers, with the exception of FICO scores, could be partly or wholly fraudulent. But coming up with a $100,000 downpayment to buy a typical $500k California house in 2005 says a lot about you.

In California, the percentage of first time homebuyers putting zero down grew from 7% under Clinton to over 40% under Bush.

Without the Bush Push to get regulators to be okay with zero down payments, the Bubble would never have gotten so inflated.

David Min,
I guess I do not care much about how Freddie and Fannie's loans did relative to loans that did really horribly.

My analogy would be encountering my kids at a party where everyone had gotten drunk and wrecked the house. I would not care if my kids got less drunk than the other kids. I would expect my kids to know better and to be leaders, not followers. Those are my expectations for Freddie and Fannie.

Recourse doesn't matter too much to a mortgage owner because by the time you get through the foreclosure process, there's hardly ever anything to get from the borrower. If you're in bad enough financial straits to lose your home, then a lawsuit for the $100,000 extra you owe is going to result in basically nothing, since the borrower probably has little if any assets to seize, and you're going to be one of many creditors trying to slice up their assets. The exception to that would be investment properties, which is I suspect why Arnold views them much more skeptically than owner-occupied residences.

"My analogy would be encountering my kids at a party where everyone had gotten drunk and wrecked the house. I would not care if my kids got less drunk than the other kids. I would expect my kids to know better and to be leaders, not followers. Those are my expectations for Freddie and Fannie."

The more accurate analogy is that F&F got to the party late because they were finishing their homework, drank beer instead of slamming shots, were not nearly as drunk when the cops got there but then have other parents show up, point at them and say, "It's all their fault."

'Okay, but being able to come up with a 20% downpayment shows something solid about the borrowers.'

That they have held on to a house for a year? If you aren't a first time buyer, it doesn't tell you much at all. Even if you are and the builder prices them 20% high and donates that to you, it doesn't. Even if you are and it comes with a low teaser rate or waived payments for a year, it doesn't. Even if you are and that 20% was an undisclosed loan, it doesn't. Even if you are and refi your 20% out after a year, or flip to another property removing your 20%, what do you stand to lose? Some fictitious gain? Consider the swings in property values in China where there is no lending at all, though falls would be less significant since no debt is associated with them.

"It is the lenders responsibility to say no to those who cannot afford to buy."

But this is wrong as a description of F&F: The law gave them a different responsibility - that they figure out ways to make homebuying affordable for thus who otherwise might not be able to buy. That was the ticking time bomb.

That was the political bias. F&F was fairly responsible in its implementation though. Its subprime bore no similarity to the garbage the investment banks turned out and buying that was an egregious mistake. This is not to say it would not have had problems. Allowing unqualified lending by anyone raises all prices above value, and allowing increasing amounts of unqualified lending lead to escalating prices so even qualified lending becomes risky. The investment banks made an industry of it.

Investment banks did not originate subprime loans, I guarantee you. They may have warehoused them, repackaged them to get ratings that would put PLS MBS on a par with F & F's paper from a bank capital risk weighting perspective and so on, but they did not have any origination function.

What you call political bias, I believe was really the core management policy.

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